Supreme Court Ruling on Cram-Down Interest Rates Creates Uncertainty for Secured

Mark G. Douglas

The ability to win court approval of a repayment plan or plan of reorganization over the

objection of a secured lender by complying with the Code's "cram-down"

requirements is one of the most important -friendly benefits of U.S. bankruptcy law. The

Code's provisions governing cram-down of a secured claim strive to strike a balance between the

"fresh start" policy imbued in federal bankruptcy law and the competing desire to compensate a

secured adequately for the risk of non-payment going forward and its inability to obtain

immediate possession of its collateral. A ruling recently handed down by the U.S. Supreme

Court, however, may have tipped the balance considerably in favor of . In Till v. SCS

Credit Corp., the High Court ruled that the appropriate rate of interest that a debtor must pay when it confirms a chapter 13 repayment plan over the objection of a should be determined according to the so-called "formula approach." Although the decision applies to secured by a on property other than a primary residence in consumer bankruptcy cases, whether or not it may have significant implications for lenders in other contexts remains to be seen.

Cram-Down in Bankruptcy

Chapters 11, 12 and 13 of the Bankruptcy Code contemplate the formulation of a repayment plan

or plan of reorganization to deal with all creditor claims, both secured and unsecured. The plan

must specify how the claim of each creditor (or class of creditors) is to be treated. Unsecured

claims can be paid in full or paid a pro rata share of whatever unencumbered assets are available

in the estate, in both cases either at the time the plan is approved, or "confirmed," by the

NYI-2168917v1 TillCramDownBRRArticleOctNov2004 JP003318 079983 - 041016 bankruptcy court, or over time. A plan can provide for payment in full of a secured claim,

surrender of the collateral to the secured creditor or, most commonly, the of a

defaulted loan and the post-confirmation debtor's resumption of -service payments.

If the plan treatment of a secured claim involves the cure of existing defaults,

compensation of the creditor for losses occasioned by the breach and reinstatement of the debt in

accordance with the terms of any pre-bankruptcy instruments or agreements that governed the

loan, the secured claim is classified as "unimpaired." In a chapter 11 case, this means that the secured creditor is deemed to accept the plan, and it does not have the right to vote on it. By contrast, if a chapter 11 plan varies any of the creditor's legal rights and remedies by, for example, altering the or maturity of a loan or substituting new collateral, the claim is said to be "impaired," and the creditor has the right to vote to accept or reject the plan.

If an impaired secured creditor votes to reject a chapter 11 plan, or a secured creditor in a

chapter 12 or 13 case objects to the plan's treatment of its claim, the plan can be confirmed only

if it satisfies the Bankruptcy Code's non-consensual confirmation, or "cram-down,"

requirements. Among other things, the statute — in chapters 11, 12 and 13 — allows a plan to

be confirmed over the objection of a secured creditor if the creditor retains its lien on the

collateral and receives property (e.g., a note) on the effective date of the plan valued at (at least)

the full allowed amount of the creditor's secured claim. The intent underlying this provision is to

place the secured creditor in the same position economically as if the debtor had chosen to surrender the collateral instead of retaining it. Given that the creditor will receive a stream of deferred cash payments rather than a lump sum of cash on the effective date, the maturity and interest rate of any new instrument governing the post-confirmation debtor's obligation are of

NYI-2168917v1 TillCramDownBRRArticleOctNov2004 JP003318 079983 - 041016 vital importance in determining whether the creditor is getting property valued at the full amount of its secured claim.

It is incumbent on the bankruptcy court to arrive at an appropriate discount factor that fairly discounts value that a plan proposes to pay a secured creditor over time. Courts disagree on how to do it. Some take the approach — the "presumptive contract rate approach" — that the interest rate originally specified in the debt instrument should govern the loan going forward.

Others reject this method, preferring an approach that focuses on the creditor's cost of funds in its business lending transactions. Another method relied on by many courts — the "coerced loan approach" — is to set an interest rate by looking at the terms of comparable loans to similar

(though non-bankrupt) debtors. Finally, some courts employ a "formula approach," whereby the cram-down interest rate is determined by augmenting a base rate (usually the national prime rate) with a risk factor add-on that can vary depending on the circumstances of the case. Which of these approaches is the right one was the question addressed by the Supreme Court in Till v. SCS

Credit Corp.

The Supreme Court's Ruling in Till

Till involved an automobile loan in the amount of less than $7,000 secured by a lien on a pickup truck valued at approximately $4,000. The loan bore an annual interest rate of 21 percent.

Under its chapter 13 plan, the debtor proposed to keep the truck, and to pay off the lienor's secured claim (bifurcated pursuant to section 506(a) into a $4,000 secured claim and an unsecured claim for the balance) over time with interest. The interest rate proposed was 9.5 percent, rather than 21 percent, a figure arrived at by augmenting the national prime rate of approximately 8 percent with a risk factor of approximately 1.5 percent.

NYI-2168917v1 TillCramDownBRRArticleOctNov2004 JP003318 079983 - 041016 The lender objected, but the bankruptcy court confirmed the debtor's chapter 13 plan.

That determination was reversed on appeal to the district court, which ruled that the original

contract rate was the appropriate one. On further appeal by the debtor to the Seventh Circuit, the

Court of Appeals endorsed a slightly modified version of the coerced loan approach, holding that

the 21 percent contract rate should serve as the presumptive cram-down rate. The Supreme

Court later agreed to hear the case to resolve a split in the circuits concerning the proper method

to apply.

The upshot was a plurality opinion. Four of the Justices joined by a concurring Justice ruled that the formula approach was the appropriate method to arrive at a cram-down interest rate. The remaining four Justices filed a dissenting opinion in which they argued that the rate specified in the original contract should be the presumptive cram-down rate to compensate the secured creditor adequately for the risk of non-payment going forward.

Writing for the plurality, Justice John Paul Stevens rejected each of the other methods,

reasoning that the formula approach "reflects the financial market's estimate of the amount a

commercial bank should charge a creditworthy borrower to compensate for the opportunity cost

of the loan, the risk of inflation, and the relatively slight risk of ." Stevens acknowledged

that this approach should be applied with the recognition that debtors in bankruptcy typically

pose a greater risk of non-payment. Still, the plurality opinion emphasized, the secured creditor

bears the burden of demonstrating what the proper risk adjustment should be.

The plurality rejected the other approaches because, in its view, they are "complicated,

impose significant evidentiary costs, and aim to make each individual creditor whole, rather than

to ensure that the debtor's payments have the required present value." By contrast, Justice

Stevens wrote, the formula approach entails a straightforward and objective inquiry into the

NYI-2168917v1 TillCramDownBRRArticleOctNov2004 JP003318 079983 - 041016 current prime interest rate and the characteristics of the bankruptcy estate and the restructured loan, rather than the creditor's circumstances or its prior relationship with the debtor.

The plurality declined to decide how the courts are to make the risk factor adjustment,

remarking merely that "[t]he appropriate size of that risk adjustment depends, of course, on such

factors as the circumstances of the estate, the nature of the security, and the duration and

feasibility of the reorganization plan." Where the likelihood of default involved is so great that it

necessitates an "eye-popping" interest rate, Justice Stevens explained, a repayment plan may not

be feasible and should not be confirmed by the court. In a concurring opinion, Justice Clarence

Thomas voted to reverse the Seventh Circuit, but went even further than the plurality. According

to him, the plain language of the Bankruptcy Code does not take into account the risk of non-

payment and the analysis should be limited to an objective analysis of the discount rate without

regard to that risk.

The dissenting Justices advocated the presumptive contract rate approach as the method most nearly designed to reflect the risk of default and the cost of collection upon default. The dissent criticized the plurality opinion for undercompensating the secured creditor: "There are very good reasons for Congress to prescribe full risk compensation for creditors. Every action in

the free market has a reaction somewhere. If subprime lenders are systematically

undercompensated in bankruptcy, they will charge higher rates or, if they already charge the

legal maximum under state law, lend to fewer of the riskiest borrowers."

Where Do We Go from Here?

Till's repercussions in the subprime lending market are bound to be anything but encouraging.

The ability of a subprime borrower to use bankruptcy as a means of stripping down a high

NYI-2168917v1 TillCramDownBRRArticleOctNov2004 JP003318 079983 - 041016 interest loan (other than one secured by a primary residence) means that lenders are going to look

elsewhere for a way to make a profit on high-risk transactions, unless they want to get out of the market altogether. This could entail higher front-end fees, even higher interest rates (where allowed by law) or other means of extracting value that can only mean bad news for the nation's riskiest borrowers. On the flip side, the plurality ruling in Till gives debtors extra leverage by placing the burden on the secured creditor to demonstrate what the risk premium for a cram- down loan should be.

Till may have broader ramifications because the plurality opinion conveys mixed signals

concerning the applicability of its rationale to cram-down interest rate determinations in contexts

other than chapter 13 cases. Referring to provisions in the Bankruptcy Code governing non-

consensual confirmation in cases under chapters 11 and 12, Justice Stevens wrote that "[w]e

think it likely that Congress intended bankruptcy judges and trustees to follow essentially the

same approach when choosing an appropriate rate of interest under any of these provisions."

However, in a footnote contrasting the absence of a readily apparent market for cram-down loans

with the robust market for debtor-in-possession financing, he wrote that "when picking a cram

down rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would

produce."

Thus, we are left to speculate concerning Till's impact on cram-down interest rates under

a chapter 11 plan. Although the ruling clearly indicates that the presumptive contract rate

approach is no longer valid, it would appear to leave the door open to argument that the formula

approach should not apply because of the existence of a DIP lending market that can act as a

benchmark for cram-down interest rates. Still, chapter 11 debtors now have additional

NYI-2168917v1 TillCramDownBRRArticleOctNov2004 JP003318 079983 - 041016 ammunition to deploy against secured lenders in hotly contested reorganization cases involving

substantially greater sums than the small amount involved in Till.

Till will likely do little to alleviate the concerns articulated by Justice Stevens regarding the burden on the courts in applying the sometimes complicated formulae employed to determine an appropriate cram-down rate using the other approaches. By declining to specify how the risk premium is to be computed, the Supreme Court has left the bankruptcy courts in much the same

position as they were before Till purported to answer definitively the cram-down interest question.

______

Till v. SCS Credit Corp., 124 S.Ct. 1951 (U.S. 2004).

NYI-2168917v1 TillCramDownBRRArticleOctNov2004 JP003318 079983 - 041016